Capital Flight

What is Capital Flight

Capital flight is a large-scale exodus of financial assets and capital from a nation due to events such as political or economic instability, currency devaluation or the imposition of capital controls. Capital flight may be legal, as is the case when foreign investors repatriate capital back to their home country, or illegal, which occurs in economies with capital controls that restrict the transfer of assets out of the country. Capital flight can impose a severe burden on poorer nations since the lack of capital impedes economic growth and may lead to lower living standards. Paradoxically, the most open economies are the least vulnerable to capital flight, since transparency and openness improve investors’ confidence in the long-term prospects for such economies.

BREAKING DOWN Capital Flight

The term “capital flight” encompasses a number of situations. It can refer to an exodus of capital either from one nation, from an entire region or a group of countries with similar fundamentals. It can be triggered by a country-specific event, or by a macroeconomic development that causes a large-scale shift in investor preferences. It can also be short-lived or carry on for decades.

Example of Illegal Capital Flight

Illegal capital flight generally takes place in nations that have strict capital and currency controls. For example, India’s capital flight amounted to billions of dollars in the 1970s and 1980s due to stringent currency controls. Liberalizing the economy from the 1990s onward reversed this capital flight as foreign capital flooded into the resurgent economy.

Capital flight can also occur in smaller nations beset by political turmoil or economic problems. Argentina, for instance, has endured capital flight for years due to a high inflation rate and a sliding domestic currency.

Currency devaluation is often the trigger for large-scale – and legal – capital flight, as foreign investors flee from such nations before their assets lose too much value. This phenomenon was evident in the Asian crisis of 1997, although foreign investors returned to these countries before long as their currencies stabilized and economic growth resumed.

Because of the specter of capital flight, most nations prefer foreign direct investment (FDI) rather than foreign portfolio investment (FPI). After all, FDI involves long-term investments in factories and enterprises in a country, and can be exceedingly difficult to liquidate at short notice. On the other hand, portfolio investments can be liquidated and the proceeds repatriated in a matter of minutes, leading to this capital source often being regarded as “hot money.”

In a low-interest rate environment, “carry trades” – which involve borrowing in low-interest rate currencies and investing in potentially higher-return assets such as emerging market equities and junk bonds – can also trigger capital flight. This would occur if interest rates look like they may head higher, which causes speculators to engage in large-scale selling of emerging market and other speculative assets, as was seen in the late spring of 2013.

During periods of market volatility, it is not uncommon to see the expressions capital flight and flight to quality used interchangeably. Whereas capital flight might best represent the outright withdrawal of capital, flight to quality usually speaks to investors shifting from higher yielding risky assets to more secure and less risky alternatives.